End of 2016 Means the End of Tax Breaks – Maybe

by | Nov 3, 2016 | Tax

High-income earners can bypass Roth IRA income limits using the backdoor Roth IRA strategy. This involves individuals to contribute to a non-deductible Traditional IRA and then converting those funds to a Roth IRA. This legal method has important tax considerations—especially for the 2024 tax year. 

Understanding the Tax Landscape 

The Pro-Rata Rule: A Key Factor 

It is important to understand the IRS’s pro-rata rule. If you have multiple Traditional IRAs with both pre-tax and after-tax contributions, the IRS requires that any conversion to a Roth IRA include a proportionate share of both. This means you cannot select only the non-taxable funds for conversion. 

Example: With $10,000 in a Traditional IRA ($6,000 pre-tax and $4,000 non-deductible), converting $4,000 to a Roth IRA makes the taxable portion proportional to the pre-tax amount. (See IRS Publication 590-B for details.) 

Impact on Taxable Income 

The taxable portion of your conversion is added to your gross income for the year, which could potentially place you in a higher tax bracket. While this might increase your short-term tax costs, the long-term benefits of tax-free growth and withdrawals from a Roth IRA often outweigh the upfront cost. 

Tip: Before converting, calculate how the added income will affect your adjusted gross income (AGI) and marginal tax rate. (Refer to IRS Publication 590-A.) 

Filing Requirements: Ensure Proper Documentation 

Form 8606: Your Reporting Companion 

In order to remain compliant, it is necessary to file IRS Form 8606. This form reports non-deductible contributions and determines the taxable and non-taxable portions of your conversion. 

Steps to Complete Form 8606: 

  • Report your non-deductible contributions 
  • Enter your total IRA basis 
  • Use the pro-rata rule to determine the taxable portion 
  • Transfer the taxable amount to Form 1040, line 4b 

Timing Matters 

Form 8606 must be attached with your 2024 Form 1040, 1040-SR, or 1040-NR. If you are not required to file a tax return, you can submit Form 8606 separately. 

Important IRS Guidelines to Keep in Mind 

Contribution and Income Limits 

For 2024, the total IRA contribution limit is $7,000 (or $8,000 for individuals aged 50 or older). Direct Roth IRA contributions are phased out at the following income levels: 

  • Married filing jointly: $230,000 $240,000 
  • Single: $146,000 $161,000 

Conversions from Traditional to Roth IRAs are permitted regardless of income level. However, it is important to note that taxes apply to the pre-tax portion of the converted amount (see 26 CFR § 1.408A-4). 

Strategic Planning Guidelines 

Timing Your Conversion 

Consider converting early in the year to maximize tax-free growth. If you anticipate a lower-income year, that could also be an ideal time to convert and reduce your tax liability. 

Long-Term Advantages 

Despite the upfront tax impact, Roth IRAs offer significant long-term benefits, including tax-free retirement withdrawals and estate planning advantages. 

Avoiding Common Pitfalls 

Accurate reporting is critical. Errors on Form 8606 can lead to penalties or IRS scrutiny. Re-verify your calculations and documentation carefully. 

How Can Our Unique Perspectives Assist You? 

MJ’s Tax Services team assists clients by maximizing tax relief and helping to maintain financial stability during challenging times. 

 

Kenneth Gibbs

CPA, Tax Partner

kgibbs@mjlm.com